New Mortgage Rules For Self-Employed Borrowers

28 May 2016, 3:34 pm

If you’ re self-employed, you must meet different requirements than a salaried person to qualify for a mortgage. The rules about how that works were updated in recent months to take an even closer look at your business income, so let’s review the rules for self-employed people borrowing for the first time, and for those who will be impacted by new rules next time they get a loan.

Self-employed borrower basics

Two of the most important things lenders review to qualify you for a mortgage are income and assets, which respectively, determine how much monthly payment you can afford and where your down payment is coming from.

When it comes to income, self-employed borrowers report income as sole proprietors or owners of entities like corporations, partnerships, or limited liability companies (LLCs).

As a sole proprietor, you will file your self-employed income on IRS Schedule C, which tracks your income and expenses for a given year.

Unlike with salaried employees, who get to use their gross income for loan qualifying, sole proprietor borrowers must qualify using their net income from Schedule C. Furthermore, lenders calculate a 24-month average of net income for sole proprietors (as opposed to sometimes requiring just one year from salaried borrowers), and if the most recent Schedule C has lower net income than the previous year, lenders will use worst-case income by calculating a 12-month average of the most recent year.

If you’re self-employed and conduct business via a corporation, partnership, or LLC, the IRS requires these entities to file separate sets of tax returns. If you own 25 percent or more of the entity, you will need to provide lenders with these full business tax returns, as well as your personal returns.

Just like with Schedule C, lenders will average income for 24 months using two years of filed business (and personal) returns, and if the most recent year is lower, they will average 12 months of the lower year.

When it comes to assets, self-employed borrowers sometimes have a lot of their money in their business, and may want to use those funds for down payment. Some lenders will let you do this, and if so, they often require that your tax preparer verifies that use of business funds for a home purchase won’t have a material impact on the business.

New rules for self-employed borrowers

In February 2016, Fannie Mae updated self-employment income calculation guidelines for borrowers who own partnerships and S corporations. These guidelines impose stricter analysis on income and debt trends of a company to determine whether the company has sufficient assets to support the withdrawal of earnings to pay its owners.

If you own an entity like this, your income from the entity shows up on a form called Schedule K-1. This form is part of the entity’s tax filing, and the figures on this form get carried over to your personal tax return as income.

This income most often comes in two main forms: “ordinary business income” and “distributions.”

New rules for self-employed borrowers now impose conditions on whether you can use either of these forms of income. For example, if distributions are greater than ordinary business income, then ordinary business income may be used to qualify. But if distributions are less than ordinary business income (or distributions don’t exist), then there are a host of guidelines to determine how you qualify.

These guidelines will be specific to your profile and they will vary by lender, so the best way to determine whether you qualify for a loan as a full or part owner of a corporation or partnership is to have a lender who can analyze your tax returns for you.